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Readings:
o Ingersoll Chapters 14 – 17
o Cochrane Chapter 17
o Shimko – Finance in Continuous Time: A Primer (from which these notes
are largely drawn)
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We will spend some time here building up the tools we need to develop the Black-
Scholes Partial Differential Equation. This will be done in a relatively informal way and
you should consult other texts if you wish to pursue these issues in more depth.
First we need to introduce an “Ito Process.” I’ll build this idea up slowly so bear with me
if you are already familiar with the concept.
This is a simple example of a discrete time stochastic process where we see a new
realization of the process B(t) at each point in time, i.e. at each time t.
The realization at any time t of the process can be arbitrarily high or low. At each time t
the innovations in the process B are unpredictable (and normally distributed). In other
words, as with all random walks, the expected value of a future realization of the process
as of date t is simply B(t). The expected change in the process is always zero and the
variance of the change depends on how far into the future you are trying to forecast.
Over one period the variance is 1. Over five periods (you know B(11) and are forecasting
B(16)) the variance is 5 (the expectation is still: E11(B(16)) = B(11)).
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Now suppose we “observe” the process more frequently than at each fixed time interval.
Let = 1/n for some arbitrary integer n > 1. We want to describe a process with the same
characteristics as the random walk described above but observed more frequently:
B(t + ) = B(t) + (t + ), with B(0) = 0 and B = B(t + ) – B(t) = (t + ) ~ iid N(0,)
Over n periods of length Δ this new process has the same expected change (or “drift” – in
this example there is none) and the same variance as the original has over one fixed time
“interval” or period.
Finally let dt, a very small increment of time (so n is very large). Define “small”
heuristically by letting dt be the smallest positive real number such that dt = 0 whenever
> 1.
Then:
B(0) = 0
B(t + dt) = B(t) + (t + dt), t [0, T]
where (t + dt) ~ iid N(0, dt)
Define dB(t) = B(t + dt) – B(t) = (t + dt), as the increments in the process B(t).
dB(t) may be thought of as a normally distributed random variable with mean 0 and
variance dt. It is often referred to as white noise. The process B(t) is a standard Wiener
process.
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Some properties of dB(t) that follow by construction are:
(1) E[dB(t)] = 0 the expected change in B(t) is zero
E[dB(t)] = E[B(t + dt) – B(t)] = E[(t + dt)] = 0 since (t + dt) ~ N(0, dt)
Note: (2) and (3) or (4) imply dB(t)dt = 0 since its expectation and variance are both zero.
(5) E[dB(t)2] = dt
E[dB(t)2] = Var[dB(t)] = dt since dB(t) = ((t + dt) and (t + dt) ~ N(0, dt) and since
E[(t + dt)] = 0 implies that E[(t + dt)2] = Var[(t + dt)]
(6) Var[dB(t)2] = 0
Var[dB(t)2] = E[dB(t)4] – (E[dB(t)2])2 = E[(t + dt)4] – dt2 = 3dt2 – dt2 = 0
Follows since if (t + dt) ~ N(0, 2), then E[(t + dt)4] = 34.
Similar to the note above, (5) and (6) imply that dB(t)2 = dt, a constant.
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These properties are important in that they demonstrate that the variance of a function of
a random variable can vanish. When this is true, the expectation sign is redundant:
E[f(dB(t))] = f(dB(t)) if Var[f(dB(t))] = 0.
These properties lead to the following “multiplication rules” that will come in handy:
dt2 = 0 – this essentially says dt is small
dB(t) dt = 0 and dB(t)2 = dt – these just eliminate the redundant expectations operator
since the variances of these functions of the random variable dB( ) are zero.
Bt0 B0 , Bt1 Bt0 , Bt 2 Bt1 ,..., Bt n Bt n 1 are independently distributed for any
0 < t0 < t1 < t2 < …< tn-1 < tn T. So the increments are independent normal
random variables. (Or simply, dB(t) - a standard Wiener process - is the
differential representation.) B is continuous in each sample path. “Continuous
means you can draw the sample path without lifting your pen from the paper.”
This is true because while dB(t) is a random variable it is of infinitesimal
magnitude (no jumps).
Notes:
(a) B is nowhere differentiable. The intuition for this is that for any point in a sample
path, the change to the right and to the left are independent random variables.
(b) Et[Bs] = Et[Bt + (Bs – Bt)] = Bt + E[Bs – Bt] = Bt – The forecast of Bs made at time t is
always Bt.
(c) Vart[Bs] = Vart[Bt + Bs – Bt] = s – t - since Bt is known at time t. This tells us about
the volatility of the realization around the guess made in note (b).
(d) Vart[Bs] as s
Despite all our time developing the idea, the standard Brownian motion is not a good
model for stock price movements. We want a process that allows for a drift in prices, i.e.
a generalization of a standard Brownian motion for which the expected change, over any
future interval of the process is non-zero (we would like to have an expected change in
price, an expected return, given the observed behavior of prices).
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Ito Process
Consider two processes
(1) a standard Brownian motion – volatility, but zero expected change (no drift)
and
(2) a process that is a constant change for each increment of time f(t) = t for some
constant α – a drift but no volatility.
Now add the two together – this is a simple version of an Ito process.
dXt = (Xt, t)dt + (Xt, t)dBt where dBt is the instantaneous increment of a
standard Brownian motion
is an Ito process. Note for notational simplicity I am writing Xt and Bt rather than X(t)
and B(t).
In the simple example given above (Xt, t) = and (Xt, t) = 1 Xt and t. In general it
need not be this simple (with and being constants) but it is always true (since both Xt
and t are known at each time t) that the values (Xt, t) and (Xt, t), which determine the
drift and diffusion of the process over the next instant in time, are known at time t.
Some examples:
(2) if (Xt, t) = (a constant) and (Xt, t) = (a constant) then gives the drift or
expected change for each increment of time. can enhance or diminish (depending on
whether > 1 or < 1) the changes in the Brownian motion.
This is an “arithmetic Brownian motion,” it allows for negative realizations and the
expected growth is linear (constant absolute growth), not the limited liability and the
exponential expected growth that stock prices exhibit. For the arithmetic Brownian
motion:
P(0) = P0
P(1) = P0 + ε(1)
P(2) = P1 + ε(2) = P0 + ε(1) + ε(2)
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Linear growth: example α = 1
f(t) = t
101
1% 100
Growth
2
100% 1
Growth
99 100
1 2
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( X t , t ) X t and ( X t , t ) X t
so that
dX t
dX t X t dt X t dBt or dt dBt
Xt
a process with a constant expected return over time and a constant variance of return.
This is a simplified but more natural model of stock prices:
Notes:
(a) if X starts positive it remains positive.
(b) X has an absorbing barrier at 0.
(c) the conditional distribution of Xs given Xt is lognormal. Ln(Xs) is normally
distributed and the conditional mean of Ln(Xs) for s > t is Ln(Xt) + (s – t) – ½ 2(s – t)
and the conditional standard deviation of Ln(Xs) is s t . The conditional expected
( s t )
value of Xs is X t e , to find expected future price inflate current price by the
continuously compounded expected rate of return.
(d) The variance of a forecast of Xs tends to as s tends to .
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Notes:
(a) X is always positive if it starts positive
(b) as X approaches 0 the drift is positive and the volatility is zero
(c) as s the variance of a forecast of Xs is finite
(d) if = ½ (as pictured above) the distribution of Xs given Xt (s > t) is non central 2
with mean ( X t )e
k ( s t )
Clearly this is an important question for derivative pricing if we think of Xt as the price of
the underlying asset then for the right f( ), Yt = f(Xt) is the price of the derivative.
dYt [ f x ( X t , t ) t f t ( X t , t ) 1 2 f xx ( X t , t ) t2 ] dt f x ( X t , t ) t dBt
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Typically it is assumed that the function f(.) is twice continuously differentiable in both Xt
and t, however, we only require that fx, fxx, and ft exist and are continuous.
Intuition: Take a 2nd order Taylor series expansion of f(Xt + dt, t + dt) around (Xt, t) then
dYt = f(Xt +dt, t + dt) – f(Xt, t).
f ( X t dt , t dt ) f ( X t , t ) f x ( X t , t )dX t f t ( X t , t )dt
1 2 f xx ( X t , t )(dX t ) 2 1 2 f tt ( X t , t )(dt ) 2
2 1 2 f xt ( X t , t )dX t dt R(residual )
Now the famous line, “it can be shown that” the residual R 0 as dt 0.
Consider the different terms and use the multiplication rules. We know what dXt, dt, and
dt2 are but what are (dXt)2 and dXtdt?
(dX t ) 2 ( t dt t dBt ) 2
t2 dt 2 t2 dBt2 2 t t dBt dt
0 t2 dt 0 t2 dt
dX t dt ( t dt t dBt )dt 0 0 0
Note that in ordinary calculus dX is small enough so that dX2 vanishes. In stochastic
calculus dX is a random variable so dX2 does not vanish (instead it converges to t dt )
2
Examples:
(1) Consider an Ito process Yt = Bt2 for t 0, where Bt is a standard Brownian motion.
Find dYt. We first identify Xt then f() and finally compute fx, fxx, and ft in order to use the
lemma.
t 0 t 1 and X t Bt so dX t dBt
Yt f ( X t , t ) X t2 and f : [0, T ] X t
then
f x ( X t ,t) 2 X t f xx ( X t , t ) 2 and ft ( X t , t) 0
and we arrive at
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dYt [ f x ( X t , t ) t f t ( X t , t ) 1 2 f xx ( X t , t ) t2 ]dt f x ( X t , t ) t dBt
[2 X t 0 0 1
2 2 12 ]dt 2 X t 1 dBt
1 dt 2 Bt dBt since X t Bt
So Yt is an Ito process with a drift () of 1 and a diffusion () of 2Bt.
(2) Yt 3 t exp( Bt )
t 0 t 1 X t Bt dX t dBt f ( X t , t ) 3 t exp( X t )
f x exp( X t ), f xx exp( X t ), f t 1
dYt [1 1 2 exp(Bt )]dt exp( Bt )dBt
(3) dX t dt dBt an arithmetic Brownian motion, can also be written X t t Bt
(since is a constant). Consider a process defined by S t S 0 exp( X t ) with S0 > 0.
f x S 0 exp( X t ) f xx S 0 exp( X t ) ft 0
and
dS t [ S 0 exp( X t ) 1 2 S 0 exp( X t ) 2 ]dt S 0 exp( X t ) dBt
[( 1 2 2 ) S t ]dt S t dBt
and we see that S is a geometric Brownian motion.
Start with a deterministic example. Suppose that a security with current value V
guarantees a flow of cash payments at the rate $1dt every instant of time forever. This is
a continuous-time equivalent of a risk-free perpetuity paying $1 each discrete period. If
the instantaneous risk-free rate is a constant r, what is the current value of the security?
First write the law of motion for V using Ito’s lemma. Here it is simple, because V does
not depend on any stochastic variable: V = V(t). Thus dV = Vtdt.
Calculate the expected capital gain from owning the security: E[dV] = Vtdt.
Thus the total expected return on the security is: Vtdt + 1dt = [Vt + 1]dt.
Now, set the total expected return equal to the risk free dollar return: rVdt = [Vt + 1]dt.
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Divide both sides by dt: rV = Vt + 1
and we get a differential equation whose value V must satisfy. Then we just have to solve
the equation for V some how. Here just guess that V cannot depend on t since it is the
value of a constant, risk-free perpetuity. Thus Vt = 0 and the solution is V = 1/r. This is
equivalent to the present value of a risk-free perpetuity in discrete time but here r is the
instantaneous risk free rate.
V = V(Xt, t) – however, just as above, since it’s perpetual (and so looks the same today as
it does in 2 years) V can’t actually depend on t only on X, so V = V(Xt). What is V(X)?
The total expected return on the security is the sum of these components:
Expected Total Return [ X V x 1 2 2 X 2 V xx X ] dt
Since the risk of the security is diversifiable, to avoid arbitrage it must be that this total
return equals rVdt (a riskless return on the security’s value). Setting them equal we
obtain a differential equation for V:
rV [ X V x 1 2 2 X 2 V xx X ]
To solve the differential equation, guess that doubling the current level of X (current cash
flow and so the expected future cash flow) will double V. Then V = X for some constant
. This implies that Vx = , and Vxx = 0. Substituting these into the differential equation
we get:
1
r X X X or and so
(r )
X
V
(r )
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This is the equation for the present value of a perpetuity growing at a constant rate of
when the riskless rate is r.
Define E[dB1dB2] = dt as the correlation between B1 and B2. We can also show that
E[(dB1dB2)2] = 0, which says the variance of dB1dB2 is zero. Therefore dB1dB2 =
E(dB1dB2) = dt.
Now suppose that Wt = f(Xt, Yt, t). The multivariate extension of Ito’s lemma has the
following Ito differential:
2 2
dWt f x dX t f y dYt f t dt 1 2 [ f xx dX t 2 f xy dX t dYt f yy dYt ]
Then
dX 2 (dt dB 1 ) 2 2 dt
dY 2 ( dt dB 2 ) 2 2 dt
dXdY (dt dB 1 )( dt dB 2 ) dt
Again if B1 and B2 were deterministic, terms of higher order than dB1 and dB2 would
vanish. Since B1 and B2 are stochastic variables terms of higher order than (dB1)2 and
(dB2)2 vanish.
Application:
Let X and Y be two real valued Ito processes with:
dX dt dB 1
dY dt dB 2
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Using Ito’s lemma
dZ [f x f y f t 1
2 2 f xx f xy 1
2 2 f yy ]dt f x dB1 f y dB 2
[Y X ]dt YdB1 XdB 2
Y (dt dB1 ) X ( dt dB 2 ) dt
YdX XdY dt
And the result follows by simple substitution.
The gains of trading strategy are given by the stochastic integral of with respect to B:
T
0
t dBt where B may be an N dimensional Brownian motion
dB
0
t t ( BT B0 )
(2) Consider a piecewise constant strategy on [0, T] so for some 0 = t0 < t1 < … < tk = T
t = (tm-1) t [tm-1, tm) m = 1, …, k
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t
t
0 t1 t2 t3 T
t dBt (t m1 )( Bt Bt
0 m 1
m m 1
)
(3) The stochastic integral is also defined for trading strategies that are not simple – the
idea is to find a simple trading strategy m that approaches the strategy in the sense that
T
Lim E [ m (t ) (t )] 2 dt 0
m
0
T T
2
Lim E m (t )dBt (t ) dBt 0
m
0 0
T T
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Then the gains of trading strategy are given by the stochastic integral of with respect
to S:
T T T
term.
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Bond – the price of the riskless bond follows the process
0 0 0
d t r t dt
where r is the (assumed constant) instantaneous riskless rate of return.
d t
0 e r t r r t (constant exponential growth) then d t r t dt
dt
Option – a European call option that matures at time T and has an exercise price equal to
k. The price process of the European call option is denoted C, where C ( S t , t ) .
Assume that C(St, t), the function relating the price of the call option to the stock price (or
the call price process), is twice continuously differentiable. Then, using Ito’s lemma
Claim
Suppose that there exists a self financing strategy (a, b) with
C ( S T , T ) aT S T bT T (so the time T payoffs on the strategy and the call are the same)
then in the absence of arbitrage opportunities the current (t = 0) price of the European call
option on the stock is given by C ( S 0 ,0) a 0 S 0 b0 0 .
Proof
Assume for contradiction that
C ( S 0 ,0) a 0 S 0 b0 0 .
Then the trading strategy (a, b, -1) (long the strategy and short the call option) has a t = 0
payoff (cost) of C ( S 0 ,0) a0 S 0 b0 0 0 and the time T payoff of this position is zero
hence it is an arbitrage opportunity.
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Then the trading strategy (-a, -b, 1) (short the strategy and long the call option) is an
arbitrage. So the replicating portfolio’s (trading strategy’s) initial cost must be the initial
option price if the strategy is self financing.
The same argument applied at each date t in the interval [0, T] implies that
( 2) C ( S t , t ) at S t bt t t [0, T ]
It follows that
dC t at dS t bt d t
at ( S t dt S t dBt ) bt r t dt
(3) ( at S t bt r t ) dt at S t dBt
so Ct follows an Ito process as defined in (3)
Using (1) and (3) and matching coefficients in dBt we see it must be true that
C s ( S t , t )S t at S t
or
at C s ( S t , t ) (the amount of the stock held at each time t is the option’s delta at that
time)
C s ( S t , t ) S t Ct ( S t , t ) 1 2 C ss ( S t , t ) 2 S t2 at S t bt r t
The 1st terms on each side of the above equation are equivalent so we can write
bt r t C t ( S t , t ) 1 2 C ss ( S t , t ) 2 S t2
rC ( S t , t ) rC s ( S t , t ) S t Ct ( S t , t ) 1 2 C ss ( S t , t ) 2 S t2 0
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This PDE can be solved in several ways – none of which we will pursue. By direct
calculation of the derivatives you can verify that the Black-Scholes formula satisfies the
PDE.
C ( S t , t ) S t N (d 1 ) k exp( r (T t )) N (d 2 )
where
Ln
St
k
2
r 2 (T t )
d1
T t
d 2 d1 T t
Finally note that this formula has the same form as the binomial models we examined, the
call price is the stock price times the option delta less the discounted value of the exercise
price times a factor determined by the distribution of the stock price process (i.e. less the
amount borrowed to form the replicating portfolio).
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